India: REIT Regime In India: Draft REIT Regulations Introduced

This hotline analyzes some of the key provisions of the draft
REIT Regulations proposed by SEBI.

While SEBI has done a commendable job in drafting the REIT
Regulation, the REIT Regime may not take off as contemplated if
specific tax treatment / exemptions are not provided to REIT as set
out herein; and

Foreign investment into REITs may not be possible unless
amendments to the extant exchange control regulations are carried
out.

The Securities and Exchange Board of India
("SEBI") finally released the draft
Securities and Exchange Board of India (Real Estate Investment
Trusts) Regulations, 2013 ("Draft REIT
Regulations"). The Draft REIT Regulations were up for
public comments until October 31, 2013, and SEBI should be formally
introducing the regime soon.

The Draft REIT Regulations are the third initiative by the
securities regulator to being about a REIT regime in India after a
failed attempt to bring in REITs in 20081 and subsequent
initiative to bring a REIT regime in the form of real estate mutual
funds ("REMF"), which also did not find
any takers.2 SEBI has finally sought to encourage
investments in real estate as an asset class, and in doing so SEBI
has clearly done a commendable job taking into account
international models and views of stakeholders.

REITs should likely emerge as a preferred form of asset backed
investment with established revenue streams, and will go a long way
in protecting the interests of investors seeking exposure in real
estate as an asset class. More importantly, REITs may infuse
additional transparency and liquidity in the Indian real estate
market. With Indian players showing an increased keenness to list
Indian real asset listings offshore, especially in SGX, SEBI's
move is likely to attract such markets onshore and increase depth
of Indian real estate capital markets. From a private equity in
real estate perspective, REITs will also create exit opportunities
for developers and financial investors allowing them to move
completed assets to REIT and provide much needed liquidity in the
market.

Although the draft REIT Regulations indicate a positive step
forward on the part of SEBI, several issues concerning taxation,
stamp duty and foreign participation remain. In this Hotline, we
analyze few of important provisions of the REIT regime and what
additional steps need to be taken to ensure efficacious utilization
of the REIT regime in India.

1. Investment Restrictions

The Draft REIT Regulations have taken cognizance of global
standards on REIT regimes and accordingly SEBI appears to have
generally followed the 90% rule on investment and distribution.
This means that REITs are required to mandatorily invest in such a
manner that:

90% of the value of the assets of the REIT are invested in
'completed' ( defined to mean properties which have
received occupancy certificates) and 'rent generating
properties' (defined to mean properties whose not less than 75%
of the area has been rented / leased out);

Developmental properties has been defined to mean properties
that are under construction (i.e. for which occupancy certificate
has not been received). For investment in such developmental
properties, REITs investment must be locked-in for a minimum period
of 3 years after completion should be leased out.

Suggestions

Investing in Limited Liability Partnerships
("LLPs"): REITs can only invest in SPVs,
which are defined to mean only body corporate as defined under the
Companies Act, 2013. That definition defines a body corporate to
include companies incorporated in India and outside India. LLPs are
classified as body corporate under the Limited Liability
Partnership Act, 2008, and therefore should qualify as an SPV under
the draft REIT Regulations. However, restriction on investment
activities of REITs would come under Regulation 18(1) which states
that REIT are allowed to invest only in securities or properties in
India. The definition of securities (as per Section 2(h) of the
Securities Co ntracts (Regulation) Act, 1956
("SCRA")) does not include partnership
interest. Therefore, Regulation 18(1) will have to be modified to
the extent of allowing REITs to also make investments in
partnership interests.

Instruments in which REITs can invest: A supplementary issue to
the modification suggested in relation to LLPs and Regulation 18(1)
is the restriction on REITs to investment only in securities and
properties in India. Since all undefined terms draw their reference
from the SCRA, which defines securities to mean marketable
securities. Since a REIT will be investing mostly in private
companies, the shares of such companies may not qualify as
'securities' as defined under the SCRA.

The 75% rental limit: The requirement to have at least 75% of
the area to be leased out at all times appears currently to be seen
on a continuous basis. This should be revised to be seen at the
time of the valuation, and there should be a 12 month correction
period to all ow for some headroom in operations as against the
current 6 month (valuation update) period. Internationally, the
focus is more on completed assets and not as much on the extent of
rentals, which is driven by markets.

Developmental property: Investment in developmental property is
only allowed to a maximum of 10% of the value of the assets of the
REIT. This 10% flexibility was provided to allow the REIT to
capitalize on capital appreciation benefits that come with
investment in under construction assets. While the 3 year lock-in
post completion is understandable to prevent speculative trading in
land, but the requirement to leasing it out may be done away with.
Further, such developmental assets should, at the option of the
manager, be considered in the 90% bucket from the time they are
completed and become rent generating.

2. Listing and other ancillary issues

The draft REIT Regulations mandate listing of the units of the
REIT within 15 days of the closure of the initial offer. Initial
offer requires filing the draft letter of offer with SEBI at least
30 days prior to filing the final letter of offer, and then making
available publicly the letter of offer for public comments for 10
days, and then providing a 5 day notice after the filing of the
final letter of offer before issuing such units to the public. Some
material requirements of note are as follows:

A REIT must hold real estate assets (and not proposed to hold)
worth INR 1000 crores prior to making the initial
offer;4

REIT can only offer its units to the public by way of an Initial
Public Offer or a Follow-on Offer;5

Trading of units of a REITs is permitted only on the
floor;6

Minimum public float shall be 25%7 and any initial
offer of its units to the public shall be for value of units not
less than 25% of the value of the REIT; and

SEBI has prescribed the minimum ticket size of a REIT unit at
INR 100,000 and further by requiring each applicant to purchase at
least two units (i.e. mi nimum investment of INR 200,000). .

Suggestions

Listing Proceeds: Value of REIT assets should be INR 1000 crores
not prior to the offer, but at the time of listing. This will help
REIT to acquire re al estate assets from the proceeds of the offer.
A requirement to have identified property tied in by way of
definitive documents and limitation on utilization of the offering
monies may be provided for.

Preferential Allotment / Rights Issue: There is no provision for
rights issue or preferential allotment. This may be added,
especially as the sponsor will be diluted if the units are only
offered to the public.

Off market deals: Trading of REIT units may also be permitted
off the market by way of negotiated deals just as in case of listed
shares. This will allow for greater investor participation.

Failure to maintain minimum public float: Currently, failure to
maintain minimum public shareholding mandates a trustee to apply
for delisting of the REIT. There should ideally be a cure period
provided within which the sponsor could divest its shareholding to
bring up the minimum public shareholding.

3. Valuations, transparency and disclosures

SEBI has prescribed extensive valuation, transparency and
disclosure requirements for REITs in the draft REIT
Regulations:

NAV to be calculated on a biannual basis;

Full valuation required once a year, including a physical
inspection of the real estate site, followed by an update on any
developments every 6 months. Specific valuation requirements for
occurrence of any material events;

Purchase or sale of a property to require full valuation by two
independent valuers, average of whose valuation shall be the
determined price for purchase / sale; and

Event based disclosures will also be required to be made to the
stock exchange and unit holders.

Valuation undertaken by any valuer shall abide by international
valuation standards and valuation standards as may be prescribed by
Institute of Chartered Accountants of India (ICAI) for valuation of
real estate, Provided that in case of any conflict, standards
prescribed by ICAI shall prevail.

Observations / Suggestions

No over-arching valuation requirements: Extensive valuation
requirements have been notified including the requirement to carry
out a full valuation of the assets of the REITs by the principal
valuer to the REIT.8 SEBI has taken a practical steps
towards valuation (unlike in previous regimes such as the REMF
product), requiring that the REIT conduct a full valuation once in
a year with physical site visits and a six month update
valuation.9

ICAI Norms for real estate valuation: Requiring the valuation of
REITs to conform with both international valuation standar ds and
valuation standards prescribed by the ICAI, and valuation standards
prescribed by ICAI to prevail in case of conflict may pose some
challenges. This is because real estate has its own peculiarities
and the ICAI's ability to value real estate remains to be seen.
SEBI's preference for ICAI may have been based from an
accountability perspective, since an Indian regulator would provide
comfort to SEBI regarding valuations carried out. It might be
helpful to suggest international valuation standards to prevail in
case of a conflict with ICAI prescribed standards.

Encumbrances on real estate assets - disclosures v. prohibition:
A key improvement (and another significant departure from the REMF
/ 2008 REIT regime) is the manner in which encumbrance on titles
have been perceived. It is common knowledge that legal proceedings
against any real estate asset can be instituted which may not
significantly affect the ownership or marketability of the real
estat e asset. SEBI has accordingly all owed for such properties to
be acquired by the REIT provided that adequate disclosures are made
considering the sophisticated nature of the investors. In contrast,
the REMF regime expected investee real estate assets to be
"free of all encumbrances and not be a subject matter of any
litigation."10 This resulted in severe restrictions
on investment into real estate, especially when many large projects
were subject matters of fraudulent and mala fide litigation. The
currently draft of the REIT Regulations appears to have addressed
this satisfactorily, only requiring the trustee to a REIT to ensure
that the real assets held by it have a proper legal and marketable
title and for adequate disclosure of any material litigat ion to be
disclosed in the valuation reports to investors of the REIT. This
will allow REITs to make investments in real estate properties
previously ina ccessible to investment vehicles.

4.Leverage

In general, SEBI is uncomfortable with leverage in investment
vehicles. However, considering that globally REITs have significant
leverage, SEBI has allowed leverage (on a consolidated basis) to a
maximum of 50% of the value of its assets. In this regard, the REIT
can avail leverage up to 25% without requiring any additional
approvals, beyond 25% a credit rating and approval of 75% of the
unit holders of the REIT (by value and number) is required to avail
any further leverage.

5.Sponsor and Manager
obligations

Sponsors held accountable: SEBI has also sought to ensure that
accountability is clearly levied on managers seeking to set up
REITs. Following is a brief summary of the obligations imposed on
sponsors:

A 'sponsor' to the REIT to hold at least 15% of the
value of the REIT assets at all times.11

Additionally, in order to ensure adequate
'skin-in-the-game', sponsors will be required to hold at
least 25% of the value of the REIT assets till a period of three
years from the date of listing of the units of the REIT.12

Further, if the REIT holds any assets over and above the 25%
limit outlined above, those holding will be locked in for a period
of one year fr om the date of listing as well.13

If a sponsor looks to move out of the REIT (i.e. sell of its
mandatory 15% holding in a REIT), it will have to first obtain
approval from 60% of the unit holders (in value and numbers)
approval as well as requiring that the re-designated sponsor also
agree to hold the minimum 15%.

Eligibility criteria for a REIT manager: A recent feature in
SEBI issued regulations has been the requirement for both manager
entities and employees of such managers to both be adequately
qualified. In the draft REIT Regulations SEBI has set out the
following as eligibility criteria:

For employees of REIT Managers: In addition to the manager level
experience, employees of the manager are also required to have at
least 2 key personnel who have the at least 5 years' experience
in property management / fund management/ advisory services or
experience in development of real estate.

Suggestions

Manager experience should be waived initially: It is likely that
many of the new entities looking to set up REITs will not have the
requisite experience at the REIT manager level. Hence, manager
level experience requirement should be waived as long as the
employee level experience is adequately met with.

6.Related party
transaction

The draft REIT Regulations have taken an extremely balanced
approach to related party transactions. Please find below a brief
description of the restrictions on related party transactions that
can be undertaken by a REIT.

Restriction on Leasing: Leasing of REIT properties to related
parties is subject to the following restrictions:14

area leased to a related party should not exceed 20% of the
underlying area of the assets;

value of assets under such lease should not exceed 20% of value
of the total underlying assets; and

rental income obtained from such leased assets should not exceed
2 0% of the value of total rental income derived from underlying
assets.

a fairness opinion is also required to be obtained by t he REIT
manager and submitted to the Trustee of the REIT in relation to
such related party transactions.

Additionally, all related party transactions whether entered
into prior to or after the initial offering shall require a full
valuation of the property being purchased, with average of the two
valuations being the purchase price.

Full valuations of the property must be provided along-with the
relation and other ancillary details relating to the relationship
of the parties concerned.

Unit holder approval for related party transactions: Any
transaction sought to be entered into by a REIT subsequent to the
initial offer, whose value exceeds 5% of the value / rental income
/ borrowings of the REIT requires the positive approval of 75% of
the unit holders of the REIT by value and number, excluding the
interested parties.

Suggestions

Unit holder approval threshold: Although it is necessary for
unit holder approvals in relation to related party transaction that
a REIT proposes to enter into, the threshold to obtain 75% unit
holder approval (by value and number) in case of a transaction i.e.
5% of the value / rental income / borrowings appears low. With the
20% limit already in place for related party transactions coupled
other restrictions in context of related party transactions, the 5%
limit should be reconsidered.

7. Voting
threshold(s)

The Draft REIT Regulations require unit holder approval in many
potentially material transactions that the REIT may carry out. The
thresholds for unit holder approval have been measured on the basis
of value and number.

Matters which require the approval of 60% of the unit holders
(by value and number) include matters such as removal or
appointment of a new trustee / manager / sponsor or principal
valuer, change in control of sponsor, as well as a requirement to
delist the units of the REIT;

Matters which require the approval of 75% of the unit holders
(by value and number) include matters such as any related party
transactions, borrowings in excess of 25% of the value of the REIT
assets, change in investment strategy, proposal by the sponsor or
manager to delist units of the REIT, change in investment strategy
and if any unit holder (or associated persons) seek to acquire more
than 50% of the units of the REIT by value.

Suggestions

Voting requirements by value and number: All actions relating to
the REITs as outlined in Clause 22 require approval from unit
holders constituting a 60% or 75% consensus both by value and by
number. It may be preferable to require approval only of unit
holders present and voting. The thresholds should also be based on
value and not number.

Exclusion of interest parties: Regulation 22(12) of the Draft
REIT Regulations excludes the votes of any related person (and
associates of such person) to a given a transaction from being
considered for the issue at hand. Therefore, since interested
parties are excluded from participating in the vote, the voting
requirement for the 60% matters should be reduced to 51% (instead
of 60%).

8.Delisting and
termination

Currently, Regulation 17 of the draft REIT Regulations outlines
the provisions for delisting of the units of a REIT. Delisting may
be carried out in the situations outlined below. Upon the
occurrence of such an event, the REIT will be required to apply to
SEBI and the stock exchange for permission to delist.

The Minimum public float falls below 25% of the total units of
the REIT;

The number of unit holders in the REIT (other than related
parties) falls below 20;

SEBI or a stock exchange requires the delisting of the REIT for
violation of the listing agreements / any provision of law or in
the interest of unit holders;

The sponsor or the manager applies for delisting of units and
receive the relevant approval from the unit holders; and

The unit holders apply for delisting of units;

Suggestions

Cl arifying on the delisting and termination process for REITs:
In the case of listed securities of a company in India, delisting
entails buy out of the securities of the Company by the Promoter by
way of a book building process. However, in case of a REIT, it must
be clarified that in conjunction with the delisting of the REIT,
its termination should also occur. Essentially, the delisting and
termination should happen simultaneously and in such an event the
REIT should sell off the assets of the REIT, which monies should be
distributed to the unit holders. The existing delisting applicable
for companies cannot and should not be made applicable to
REITs.

9. Perpetual investment vehicles
for REITs

In our experience in the past, SEBI has insisted on a term being
fixed for venture capital funds / alternative investment funds,
even when the relevant regulations were silent in that aspect.
However, we understand that, in the present instance, SEBI may be
comfortable with REITs being conceived as perpetual investment
vehicles which can only be terminated in accordance with its terms
and accordingly, SEBI may not insist on a fixed term maturity. This
would be in line with the global practice, where REITs are
structured as perpetual investment vehicles which do not have fixed
term of maturity.

10.Road Ahead

Several issues need to be addressed to ensure optimum
utilization of the regime.

Taxes on transfer

Currently, most completed real estate assets will be housed in
SPVs, and due to substantial costs the promoters of such SPVs (who
will also likely be the sponsors of the REIT) may not be able to
transfer such assets to REITs for investment purposes. Such costs
will be in the region of (i) stamp duty on transfer of land in the
region 6 - 8%; and (ii) capital gains tax on the transfer.
Promoters would not be able to transfer the real estate asset of
the SPV at nominal value as the ready reckoner value will be deemed
to be the sale price received (under section 50 C if the asset is
held as capital asset, or under 43CA if the asset is held as stock
in trade). To that extent, capital gains and stamp duty on such
transfer to the REIT should be exempt.

Tax on acquisition of SPV

If the promoters were to transfer their shares in the SPV to the
REIT, then in all likelihood such transfer would happen for a
combination of cash and kind (units of the REIT). We suggest that
capital gains on transfer of shares for the units of a REIT should
not be treated as a 'transfer' and capital gains tax be
levied only when the units of the REIT are transferred. This is
because there is no monetization on receipt of the units of the
REIT, especially considering that the promoter will be locked in to
the extent of 25% for three years.

Tax on distribution of income from REITs

If the REIT holds the SPV, any distributions would be subject to
corporate level tax on at the rate of 30% (exclusive of surcharge
and cess) plus a divided distribution tax of 15% if the SPV seeks
to distribute dividends. Hence, we suggest that the SPV (if held by
a REIT) should be exempt from all corporate level taxes,
distribution taxes and MAT. Further, the REIT should be given a
pass through status (in the same manner as venture capital funds as
outlined in Section 10(23FB) of the Income Tax Act, 1961) ensuring
only a single level of tax at the hands of the unit holder.

Tax on trading in the units of the REIT

Additionally, since REITs are required to be mandatorily listed
on the stock exchange, the same lowered rate of capital gains tax
(between 0% and 15%) should be afforded to sale and purchase of
units of a REIT (on payment of STT) in a stock exchange as provided
to listed shares and units of mutual funds. Amendments will have to
be made to Income Tax Act, 1961 and Chapter VII of the Finance Act,
2004 (which set up the securities transaction tax regime in
India).

Foreign investments

For units of a REIT to be mandatorily listed, the first step
will be to define units of a REIT as a security under the SCRA.
Currently, units of a REIT may not even qualify as a
'security'. The second step will be to amend SEBI FII / QFI
regulations to allow portfolio investments in units of a REIT.
Third step will be to amend the exchange control regulations to
facilitate FII / QFIs to subscribe to units of a REIT. Capital
account transaction rules will also need to be amended to exclude
REITs from the definition of 'real estate business', as
even foreign portfolio investment is not permitted in real estate
business. Investment in yield generating assets may qualify as
'real estate business'.

CONCLUSION

As REITs develop, healthcare, infrastructure and other
stabilised yield generating assets may also be rolled into REITs.
Such framework was initially considered by the SEBI and will likely
be the next progressive step. However, the immediate need of the
hour is to address the issues relating to tax and foreign
investments without which the REIT regime may not take off as
contemplated.

Footnotes

1 The first draft REIT Regulations were introduced in the
December 2007. Please see our then Hotline analyzing the 2008 REIT
Regulations titled 'SEBI ACTS SANTA: GIFTS REITS TO
INDIAN REAL ESTATE SECTOR'

2 Subsequently, SEBI instead sought to bring REITs
through the SEBI Mutual Funds regime as a real estate mutual fund
("REMF"). However, the REMF could not
take off due to issues relating to tax, restrictive investment and
asset criteria and certain other conditions. Please see our then
Hotline analyzing the REMF regime when it was introduced, titled
'WILL REMFS OUTSHINE REITS?'

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